Brave New World

Rally to continue? 18/04/2009

Risk appetite has been the most important driver of currency markets in the last few months. This is has been due to universally low interest rates, poor economic growth prospects for all the main economies and extremely high volatility. With the rate of economic decline appearing to level off – the “second derivative” as Morgan Stanley economists have recently taken to calling it- and declining levels of volatility, as so much bad news has been priced into the market there is little left to surprise, the panic and flight to risk aversion that had until recently gripped the market, has weakened. More encouraging economic numbers and better than expected corporate earnings from the financial sector have gone some way towards convincing the market that the downturn does indeed have a bottom.

The recent equity market rally has been driven by short term money. Real money investors remain on the sidelines until they are sure that there has been a real sea change in sentiment. Unfortunately, there are significant reasons to suspect that risk appetite is already stumbling and, given the that the rally is about to enter its seventh week- there could be a significant correction. The market rally is tailing off, with a small gain this week could signify that the market is running out of steam; a negative “second derivative” in itself. Economic data from the US this week was indeed better than expected, but the S&P gained only 1% a week. 

Equity market performance suggests that the real economy should expect a strong upturn un the future. US economic data released earlier this week suggest that economic deterioration is slowing. Bulls point to the New York and Philly regional indices which both surprised to the upside and the University of Michigan sentiment  index which gave its best reading since September. This is indeed cause for hope, but the data merely suggests that expectations for further deterioration have lessened, not that expectations for an improvement have increased. The equity market is behaving as if the problems which have created the financial and economic crisis have been solved; namely the toxic assets on banks’ balance sheets, a sharp reduction in (primarily) US domestic consumption as a direct result of lower household wealth and a return to savings linked to a steadily falling housing market. In fact, none of these problems has been adequately addressed. Continuing signs of a decline in US consumption will bear heavily on the world economy and equity markets until a suitable replacement engine can be found. Similarly, the market will become increasingly nervous in the run up to the results of the US stress test for banks due in early May. If all banks pass, markets will believe the test was too lenient. If some banks fail to pass the test, without immediate government support bankruptcy will ensue. In both cases, stress on the world financial system is likely to resume. 

In the meantime, the week ahead should provide important direction for global markets with the meeting of G7/G20 finance ministers at the end of the week. The growing game of currency politics being played between the US and Chinese authorities will be a particular driver. Company earnings season gets into full swing with 33 major companies in the US due to report, including banks and credit card companies. There are risks next week, but the real risks lie in the weeks ahead.